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Anticipating higher interest rates, bond investors have been flocking to short-term fixed income. That's a good idea generally speaking, but the nuance with which a fund manager approaches this space can make a big difference.

As lead manager of the
MassMutual Premier Short-Duration Bond
fund (ticker: MSTDX), Ronald Desautels has bested the average short-duration fund over one, three, five, and 10 years, according to Morningstar. In its 25-year history, the $623 million fund, run by Babson Capital Management on behalf of Massachusetts Mutual Life, has had only one calendar year of negative returns—it ended 2008 down a mere 0.25%.

"It's been a very successful product for us," says the understated Desautels, 58, who has managed Short-Duration Bond since its 1989 inception.

Bond manager Ronald Desautels is negotiating a tough time in the markets by mitigating interest-rate and credit risks in shorter-term bonds.
Jared Leeds for Barron's

In the second half of last year, funds with average durations between one and 3½ years attracted $10 billion in new cash, even as other taxable bond funds have lost $53 billion to outflows, according to Morningstar.

Short-Duration Bond's managers invest in Treasuries, corporate bonds, municipal bonds, and asset-backed securities. Their strategy is straightforward: They dial the portfolio's average duration up and down based on changes in the yield curve.

Duration is a measure of a bond's sensitivity to interest-rate changes. The yield curve represents the spread between short- and long-term Treasury bonds. A steeper yield curve means that longer durations offer relatively more yield, making them more attractive. When the curve is less steep, there's less potential reward to justify the risk of a longer duration; in that case, staying towards the short end can help protect your initial investment.

Based on the shape of the yield curve, Desautels slides the fund's average duration between zero and three years. With the yield curve having widened in recent months, the fund's average duration has jumped to 1.2 years from 0.7 years. "I pay a lot of attention to the shape of the yield curve," says Desautels. "My spreadsheets could fill the floor of a large conference room."

Short-Term Bond grew out of MassMutual's desire in the late 1980s for a fund that could deliver more yield than a money-market fund, but without the risk of a longer-duration bond fund. Desautels and his team, who then worked within the insurance giant's in-house investment arm, back-tested half a dozen strategies before settling on what they call "active short duration."

"With active short duration, we were able to add quite a bit of additional yield without a lot of additional risk," says Desautels. That risk management is evident: Over five years, Short-Duration Bond has participated in about 75% of the market's upside but just 1.46% of its downside, according to Morningstar.

In 2000, MassMutual's investment arm was spun into David L. Babson & Co., a Boston-based investment management firm that MassMutual had bought in 1995. Babson's offices sit three miles west of its parent's campus.

The team emphasizes that they don't predict changes in interest rates; they simply respond to changes in the yield curve. "We don't guess, estimate, or project where rates are going to be," says Desautels. Adds longtime co-manager David Nagle: "A lot of bond-fund managers have blown up their performance trying to get that right."

Babson Capital's strength in credit research and cash-flow analysis—both domestically and globally—has helped it navigate the riskier but potentially more profitable end of the investment-grade spectrum. Indeed, nearly a third of Short-Term Bond's holdings are BBB-rated paper, compared with 18% for its average rival. The fund typically holds very small positions in such riskier bonds, Desautels says.

One of the portfolio's best-performing BBB issues over the past year is Arrow Electronics, in Englewood, Colo.; the Babson Capital team expects improving fundamentals from the supplier of computer components. Another holding, Pitney Bowes, the Stamford, Conn.–based postage-meter company, is successfully executing a turnaround plan under new management.

And the debt of LyondellBasell Industries, a Netherlands-based maker of plastics, chemicals, and fuel, is enjoying an upswing thanks to improving earnings and credit ratings.

Researching and implementing such a flexible-target strategy is an investment that few managers have been willing to make, says Desautels. Perhaps more importantly, most fund managers are more comfortable managing portfolios with locked duration targets rather than those with a flexible target, he says.

There are a few blemishes in Desautels' track record. But one came in 2012, when the fund trailed its category average by half a percentage point. Desautels insists he's not concerned with short-term results, however. The fund's approach "is truly a cycle strategy," he says. "We pay tremendous attention to longer-term periods of return while recognizing that in the short term performance may at times lag."

A self-proclaimed numbers geek, Desautels earned an accounting degree from the University of Connecticut in 1977, but his accounting career lasted just two years. "I didn't want to chase pennies for the rest of my life," he says. Desautels' true calling, it turns out, was chasing the yield curve.